Liability Dynamics: A New Analytic Framework for Counterparty Risk Management? If Data on Funding Liquidity Can Be Organized into a Theory of Liability Dynamics, It Can Be Used to Supplement Credit Ratings, VaR, and Qualitative Risk Measures in Evaluating Counterparty Risk

By Blount, Ed | The RMA Journal, March 2009 | Go to article overview

Liability Dynamics: A New Analytic Framework for Counterparty Risk Management? If Data on Funding Liquidity Can Be Organized into a Theory of Liability Dynamics, It Can Be Used to Supplement Credit Ratings, VaR, and Qualitative Risk Measures in Evaluating Counterparty Risk


Blount, Ed, The RMA Journal


In October 2008, then SEC Chairman Christopher Cox was asked if he thought liabilities were a fruitful field for further regulatory development.

"Yes. The run-on-the-bank experiences of Bear and Lehman, driven by a crisis of confidence, had never occurred before in investment banking," he said. "The rapid flight of customers, such as hedge funds, illustrated the benefits of more 'sticky' sources of financing. The liability side of the analysis certainly has the full attention of regulators."

The Crucible for Calibration

After the collapse of Bear Stearns and Lehman Brothers, investors were shocked to learn that even senior executives failed to appreciate how vulnerable their firms were when denied access to short-term funding markets. Similar funding denials preceded the de facto collapses, shotgun mergers, or bailouts of other large investment banks, as well as AIG, Citigroup, Fannie Mae, and Freddie Mac.

As Fed chairman Ben Bernanke explained, such institutional failures resulted from "poor risk management [since] the spreading of risk, one of the purported benefits of the originate-to-distribute model, proved to be much less extensive than many believed. When investors were no longer willing or able to finance new structured credit products, many of the largest financial institutions had to fund instruments they could not readily sell or had to meet contingent funding obligations for which they had not adequately planned." Simply put, contingent liabilities took down some of the largest, highest-rated counterparties in the world.

The financial market does not suffer shocks lightly. According to a report by the Basel-based Bank for International Settlements (BIS), the central bank for central banks: "Following Lehman Brothers' bankruptcy on 15 September, conditions in financial markets deteriorated to new lows. Liquidity demand surged while perceived counterparty risk rose to record highs, resulting in the virtual shutdown of the unsecured interbank lending market. At the same time, flight to safe-haven government securities intensified. ... Investors piled into Treasuries and became extremely unwilling to repo them out."

The high tensions in credit markets could be seen, paradoxically, in the low prices paid for overnight cash loans in the U.S. repo and securities lending markets. "As the available supply of Treasury collateral dropped," reported the BIS, "those market participants willing to lend out Treasuries were able to borrow cash at increasingly cheap rates. At times, this effect pushed U.S. GC [general collateral] repo rates down to levels only a few basis points above zero." Conversely, those participants without high-quality collateral were rapidly forced to pay far more in the funding markets.

In other words, savvy investors wanted no part of the U.S. banking sector's unsecured deposit liabilities. To avoid the risk, they were willing to forgo almost all the return in order to hold more secure U.S. government liabilities-that is, Treasury bonds. That's not an unusual view for some investors, even without a crisis, but the significance in this case lies in the clarity of the resulting market effect. Rates paid by risky borrowers in the U.S. funding markets moved sharply and quickly away from rates paid by more secure borrowers. Moreover, the BIS report noted that the pricing effect was markedly different in the euro repo markets during the same period, due to the differences in counterparty-network composition and breadth, scale of activity, scope of collateral, and so on.

For risk analysts studying this market months later, it became clear that these herd-like global movements and regional market reactions in the autumn markets of 2008 could be used to help calibrate the local effect of interactions among smaller networks of lenders and borrowers in later cash and securities markets.

[ILLUSTRATION OMITTED]

In essence, a set of liability-driven metrics has been uncovered to assist risk managers during more normal conditions. …

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